Earnings Warnings And CEO Welfare

Masako N. Darrough
City University of New York – Baruch College – Stan Ross Department of Accountancy

Linna Shi
State University of New York at Binghamton – School of Management

June 20, 2016

Journal of Business Finance and Accounting, Forthcoming

Abstract:

Some CEOs decide voluntarily to issue a warning when they expect a negative earnings surprise. Prior research suggests that warnings contain incremental information beyond actual earnings; warning firms tend to experience permanent earnings decreases. This paper investigates whether compensation committees take warnings into account in setting CEO compensation. We find that warnings are significantly negatively (positively) associated with CEO bonus (option grants), suggesting that compensation committees adjust CEO compensation towards a more high-powered structure after warnings. However, the sensitivity of bonus or option grants to earnings and stock returns is not affected except for bonus sensitivity to stock returns. We also find weak evidence of an increase in forced CEO turnover after warnings, accompanied by a significant increase in its sensitivity to stock returns. This benefits CEOs with higher ability but imposes more risk on other CEOs. These findings provide a partial explanation of why not every CEO facing a negative surprise decides to issue a warning. Our results are robust to various specifications. In particular, the impact of warnings on compensation appears invariant to the timing or the number of warnings. Overall, these findings suggest that the signal from warnings is used in determining CEO compensation and retention.

Earnings Warnings And CEO Welfare – Introduction

When faced with an impending negative earnings surprise, CEOs have to decide whether or not to voluntarily issue earnings warnings. A warning (defined as negative earnings guidance) might be issued when a firm expects that its actual earnings will fall short of existing market expectations. Such a warning is typically issued near or after the end of a fiscal quarter, but before quarterly or annual earnings are announced.1 The extant literature on U.S. firms documents a number of reactions to the issuance of an earnings warning, including: an adjustment by the market of its expectations, typically through a reduction in share prices (Kasznik and Lev, 1995; Tucker, 2007; and Das et al., 2012); a decrease in litigation costs (Skinner, 1997); less information asymmetry among investors (Coller and Yohn, 1997); increased analyst following (Lang and Lundholm, 1996); and increased chances of meeting or beating analysts’ forecasts (Brown et al., 2005; Cotter et al., 2006; and Keskek et al., 2013).2 Given that these firms tend to be performing poorly (or at least below market expectations), the issuance of warnings appears to be an integral part of the timely disclosure of bad news.

Timely disclosure of news is important to investors, especially when firms expect to fall short of market expectations. Issuing warnings ahead of actual earnings announcements brings some benefits to firms in this position, such as reducing the potential class period in the case of litigation, while incremental costs appear to be small since negative market reactions are likely to occur anyway, at the time either of warnings or of actual earnings announcements. One would expect that most firms facing a negative earnings surprise would issue warnings so that investors would not be caught off guard. Thus, it is surprising to find that a relatively small number of companies issue these warnings when they face negative earnings surprises; prior literature reports that less than 25% of firms preempt negative earnings surprises by issuing warnings (Skinner, 1994; and Kasznik and Lev, 1995). This finding suggests that the decision on whether or not to issue warnings is not as straightforward as one might think. Since this decision is likely made by CEOs (and CFOs) rather than firms as a whole (Bamber et al., 2010), an agency problem might exist. In this paper, we examine the consequences of warnings that might directly accrue to CEOs who have to decide whether or not to issue these warnings. Our overall research question is whether and how boards of directors make use of voluntary disclosures in the form of warnings in determining CEOs’ compensation and retention/turnover.

Research that directly examines the relationship between management earnings guidance and CEO compensation is limited.4 De Franco et al. (2013) examine whether firms that issue management guidance (favorable, neutral, and negative guidance combined) exhibit a higher sensitivity of CEO compensation to firm performance. They argue that management guidance improves transparency, which enhances the board’s ability to assess CEO activities, and find that firms with management guidance indeed have higher pay-performance sensitivity (PPS) to both accounting and stock returns. Research on the association between management guidance and CEO turnover is also limited. The study by Lee et al. (2012) is an exception. They find evidence that the probability of CEO turnover decreases with management guidance accuracy, indicating that management guidance acts as a signal regarding the CEOs’ ability to handle business uncertainty.

While the above articles demonstrate that management guidance is associated with PPS and CEO turnover, they do not explicitly examine how the issuance of warnings affects CEOs’ compensation and turnover. Despite various benefits that firms as a whole receive from issuing warnings, only a relatively small percentage of firms issue such warnings. This phenomenon cannot be explained unless we consider the welfare consequence of those who must decide whether warnings should be issued. This study tries to fill the void in the literature by examining how warnings affect both CEOs’ bonus and equity-based compensation and CEO turnover.